Coggan the money machine; how the city works, 6e (2009)

Introduction 1 THE INTERNATIONAL FINANCIAL REVOLUTION 2 MONEY AND INTEREST RATES 3 THE RETAIL BANKS AND BUILDING SOCIETIES 4 INVESTMENT BANKS 5 THE BANK OF ENGLAND 6 THE MONEY MARKETS...

Philip Coggan

The Money Machine

How the City Works

SIXTH EDITION

PENGUIN BOOKS

Introduction

1 THE INTERNATIONAL FINANCIAL REVOLUTION

2 MONEY AND INTEREST RATES

3 THE RETAIL BANKS AND BUILDING SOCIETIES

4 INVESTMENT BANKS

5 THE BANK OF ENGLAND

6 THE MONEY MARKETS

PENGUIN BOOKS

The Money Machine

After being educated at Sidney Sussex College, Cambridge, Philip Coggan became Assistant Editor

of Euromoney Currency Report and Euromoney Corporate Finance He was a journalist for the

Financial Times from 1986 to 2006, including spells as personal finance editor, economics

correspondent, Lex columnist and investment editor He now works for the Economist where he

writes the Buttonwood column in addition to being Capital Markets Editor In 2009, he was awardedthe title of Senior Financial Journalist of the Year by The Wincott Foundation

Finance has moved on to the front page The collapse of some of Britain’s leading banks in 2007 and

2008 has cost the taxpayer billions It has brought the City, once seen as Britain’s most successfulindustry, into disrepute Many people think the financial sector has been too powerful, imposing free-market dogma on unwilling populations They resent the way that financiers make millions in bonuseswhen times go well but expect the taxpayer to bail them out when things go badly, as they did in 2008

This ambivalent attitude towards financiers dates back over centuries Roman emperors and

medieval monarchs had to flatter financiers when they needed to borrow money; the attitude quicklyturned to revulsion when the time came to pay it back Whole populations have been caught up infrenzies of speculation dating back from Dutch tulip mania through the South Sea Bubble to the

Florida land boom of the 1920s Individual financiers have found it laughably easy to buy popularitywhen their schemes were prospering (think of Robert Maxwell) But there have been no shortages ofcommentators saying ‘I told you so’ when their empires subsequently collapsed

Perhaps the public has tended to treat the subject of finance as a soap opera (complete with heroesand villains) because too few people attempt to understand the workings of the financial system

Although the details of individual financial deals can be very complex, there are basic principles infinance which everyone can understand and which apply as much to the finances of Mr Smith, thegrocer, as to Barclays Bank The more fully people understand these principles, the more they will beable and willing to criticize, and perhaps even participate in, the workings of the financial system.Like all areas of public life, it needs criticism to ensure its efficiency

Even those who do not own shares should care about how the City performs It is one of the UK’sbiggest industries and a vital overseas earner in areas such as insurance and fund management

of individuals and lend them to house buyers who want mortgages

Why do the savers not just lend directly to borrowers, without the intervention of financial

institutions? The main reason is that their needs are not compatible with those of the end borrowers.People with mortgages, for example, want to borrow for twenty-five years Savers may want to

withdraw their money next week In addition, the amounts needed are dissimilar Companies andgovernments need to borrow amounts far beyond the resources of most individuals Only by bundlingtogether all the savings of many individuals can the financial institutions provide funds on an

borrow from the banks or raise capital in the form of shares or bonds Without this capital it would beimpossible for companies to invest and for the economy to expand.

The second major set of borrowers is governments No matter what their claims to fiscal rectitude,few governments have ever managed to avoid spending more than they receive The UK governmentand other nations’ governments come to the City to cover the difference

Who wants to lend? In general, the only part of the economy which is a net saver (i.e its savingsare greater than its borrowings) is the personal sector – individuals like you and me Rarely do welend directly to the government or industry or other individuals: instead we save, either through themedium of banks and building societies or, in a more planned way, through pension and life assuranceschemes Lending, saving and investing are thus different ways of looking at the same activity

So financial institutions are there to channel the funds of those who want to lend into the hands ofthose who want to borrow They take their cut as middlemen That cut can come in three forms: bankscan charge a higher interest rate to the people to whom they lend than they pay to the people fromwhom they borrow, or they can simply charge a fee for bringing lender and borrower, or issuer andinvestor, together Over the last twenty years, they have increasingly added a third activity: tradingassets This contributed to the credit crunch that started in 2007

There is no doubt that financial institutions perform an immensely valuable service: imagine lifewithout cashpoint cards, credit cards, mortgages and car loans Even those Britons who do not have abank account would never be paid if the companies for which they work did not have one Indeed, thecompanies might not have been founded without loans from banks

It is important, when considering some of the practices discussed in this book, to remember that thebusiness of financial institutions is the handling of money Some of their more esoteric activities, likefinancial futures, can appear to the observer to be mere speculation But speculation is an

unavoidable part of the world of financial institutions They must speculate, when they borrow at onerate, that they will be able to lend at a higher rate They must speculate that the companies to whomthey lend will not go bust To criticize the mechanisms by which they do speculate is to ignore thebasic facts of financial life

Financial institutions are a vital part of the British economy Whether the rewards they receive are

in keeping with the importance of the part they play is another question, which we will examine in thefinal chapter

THE INSTITUTIONS

The most prominent financial institutions are the banks, which can be divided roughly into two

groups, commercial (retail) and investment, formerly known as merchant, banks The former rely onthe deposits drawn from ordinary individuals, on which they pay little or no interest and which theyre-lend at a profit Commercial banks must ensure that they have enough money to repay their

customers, so they need to own some safe assets they can sell quickly The latter group traditionallyrelied more on fees earned from arranging deals such as takeovers; nowadays, these banks also getheavily involved in market trading However, the division between the two groups is not clear-cutsince many commercial banks have investment banking arms

The second group of financial institutions, known as the investment institutions, include the pensionfunds and life insurance companies They bundle together the monthly savings of individuals and

invest them in a range of assets, including the shares of British and foreign companies and

commercial property This is a vital function, since industry needs long-term funds to expand Bankslend money to industry, but by tradition they have been less ready to invest for long periods Pensionfunds can count on regular contributions and can normally calculate in advance when and how muchthey will have to pay out to claimants Life insurance companies have the laws of actuarial

probabilities to help them calculate their likely outgoings

But pension funds and insurance companies are less significant, in stock market terms, than theyused to be Nowadays, the investors who dominate the market tend to be more aggressive and short-term in outlook Two prominent groups, hedge funds and private equity firms, will be discussed atlength

The third main group is the exchanges, which provide a market for trading in the capital that

companies and governments have raised People and institutions are more willing to invest money intradeable instruments, since they can easily reclaim their money if the need arises The best-knownexchange in the UK is the Stock Exchange

Within and outside these groups is a host of institutions which perform specialized functions Thebuilding societies have already been mentioned, but we will also need to look at the Bank of England,insurance brokers and underwriters, to name but a few

THE INSTRUMENTS

Chapter 2 examines in detail questions about the definition of money and the determination of interestrates But for the moment the best way to understand the workings of the financial system is to stopthinking of money as a homogeneous commodity and instead to think of notes and coins as constituting

one of a range of financial assets It is the liquidity of those assets that distinguishes them from each

other The liquidity of an asset is judged by the speed with which it can be exchanged for goods

without financial loss

Notes and coins are easily the most liquid because they can be traded immediately for goods Atthe opposite extreme is a long-term loan, which may not be repaid for twenty-five years Between thetwo extremes are various financial assets which have grown up in response to the needs of the

individuals and institutions that take part in the financial markets

Essentially, financial assets can be divided into four types: loans, bonds, equities and derivatives.

Loans are the simplest to understand One party agrees to lend another money in return for a

payment called interest, normally quoted as an annual rate It is possible, as in the case of many

mortgages or hire-purchase agreements, for the principal sum (that is, the original amount borrowed)

to be paid back in instalments with the interest Alternatively, the principal sum can be paid back inone lump at the end of the agreed term

Bonds are pieces of paper like IOUs, which borrowers issue in return for a loan and which are

bought by investors, who can sell them to other parties as and when they choose Bonds are normallymedium- to long-term (between five and twenty-five years) in duration The period for which a loan

or bond lasts is normally known as its maturity, and the interest rate a bond pays is called the

coupon Shorter-term bonds (lasting three months or so) are generally known as bills.

Equities are issued only by companies and offer a share in the assets and profits of the firm, which

has led to their being given the more common name of shares They differ from other financial

instruments in that they confer ownership of something more than just a piece of paper In the financial

sense, shareholders are the company, whereas bondholders are merely outside creditors.

The initial capital invested in shares will rarely be repaid unless the company folds (But shares,like bonds, can be sold to other investors.) The company will generally announce a semi-annual orquarterly dividend (a sum payable to each shareholder as a proportion of the profit), depending on thesize of its profits All ordinary shareholders will receive that dividend However, it is not

compulsory for companies to pay dividends Some companies choose not to do so because they wish

to reinvest all their profits with the aim of expanding the business Others may omit paying a dividendbecause they are in financial difficulties

Equity investors only get paid after the demands of lenders and bond-holders are satisfied If acompany gets into trouble, equity investors may well lose the bulk of their money whereas

bondholders have a chance of getting a chunk of their capital back The good news for equity

investors is they get all the upside Whereas the claims of lenders and bondholders are fixed, equityowners benefit from a company’s growth

That brings us to one of the most important principles in finance Greater risk demands greater

reward If a lender is dubious about whether a borrower will be able to repay the loan, he or she will

charge a higher rate on that loan Why lend money at 10 per cent to a bad risk when you can lend

money at 10 per cent to a good risk and be sure that your money will be returned with interest? Tocompensate for the extra risk, you will demand a rate of, say, 12 per cent, for the borrower with adoubtful reputation

Derivatives are financial assets that are based on other products; their value is derived from

elsewhere Among the best-known derivative instruments are futures, options and swaps.

They perform a number of functions, allowing some people to insure themselves against price

moves in other assets and others to speculate on price changes These functions allow derivative

users to get involved in hedging and leverage Hedging is the process whereby an institution buys or

sells a financial instrument in order to offset the risk that the price of another financial instrument orcommodity may rise or fall For example, coffee importers buy coffee futures to lock in the cost oftheir raw materials and reduce the risk that a rise in commodity prices will cut their profits

Leverage gives the investor an opportunity for a large profit with a small stake Options, futures

and warrants all provide the chance of leverage because their prices vary more sharply than those ofthe underlying commodities to which they are linked These concepts are more fully explained in

Chapters 12 and 13

ALCHEMY

Financial institutions must perform a feat of alchemy They must transform the cash savings of

ordinary depositors, who may want to withdraw their money at any moment, into funds which industrycan borrow for twenty-five years or more This process involves risk – the risk that the funds will bewithdrawn before the institutions’ investments mature They must therefore demand a higher return fortying up their money for long periods, so that they can offset that risk This brings us to a second

important principle of finance Lesser liquidity demands greater reward The longer an investor

must hold an asset before being sure of achieving a return, the larger he will expect that return to be.However, this is not an iron rule In Chapter 2 we shall see how, for a variety of reasons, long-term

interest rates can be below short-term rates.

The range of financial assets extends from cash to long-term loans Cash, the most liquid of assets,gives no return at all A building society account that can be withdrawn without notice might give areturn of, say, 5 per cent In the circumstances, why should lenders make a twenty-five-year loan atless than 5 per cent? They would be incurring an unnecessary risk for no reward So lenders generallydemand a greater return to compensate them for locking up their money for a long period In the sameway some banks and building societies offer higher-interest accounts to those who agree to give

ninety days’ notice before withdrawal The borrowers (in this case, the banks and building societies)are willing to pay more for the certainty of retaining the funds

Bonds and shares are usually liquid in the sense that they can be sold, but the seller has no

guarantee of the price that he or she will receive for them This differentiates them from savings

accounts, which guarantee the return of the capital invested Thus bond- and shareholders will

generally demand a higher return For both, that extra return may come through an increase in the price

of the investment rather than through a high interest rate or dividend This applies especially to

shares As a consequence, the dividends paid on shares is often, in percentage terms, well below theinterest paid on bonds such as gilts (highly reliable investments because they are issued by the UKgovernment)

THE CITY’S INTERNATIONAL ROLE

The City, of course, plays a role that far exceeds the dimensions of the national economy It is thisrole that the supporters of the City invoke when they defend its actions and its privileges And it is topreserve this role that the City has undergone so many changes in recent years

In the nineteenth century the City’s importance in the world financial markets reflected the way inwhich Britannia ruled the waves Britain financed the development of Argentinian and North

American railways, for example By 1914 Britain owned an enormous range of foreign assets, whichbrought it a steady overseas income Much of the world’s trade was conducted in sterling because itwas a respected and valued currency

The two world wars ended Britain’s financial predominance Foreign assets were repatriated topay for the fighting As the Empire disintegrated, so too did the world’s use of sterling as a tradinginstrument Just as the US emerged as the world’s biggest economic power, so New York challengedLondon for the market in financial services and the dollar took over from sterling as the major tradingcurrency It seemed that Britain and the City would become backwaters on the edge of Europe

One thing saved the City The US, which had regarded banks with suspicion since the Great Crash

of 1929, did not welcome the growth of New York as a financial centre The US authorities began toplace restrictions on the activities of its banks and investors International business began to flowback to London, where there were fewer restrictions The Euromarket grew into the most importantcapital market in the world and made London its base

The revival of the City in the 1960s brought many foreign banks to London and they have stayed asBritain’s capital has become one of the world’s three great trading centres, together with New Yorkand Tokyo But the challenge is never-ending The development of the European single currency

caused some to fear that London could lose its place to Paris or Frankfurt; so far, the challenge hasbeen seen off fairly easily

However, London does face what has been called the ‘Wimbledon’ problem; Britain may be thevenue for a great tennis tournament but the best players come from elsewhere The London StockExchange has narrowly fought off takeover bids from the Frankfurt exchange and from the US

electronic market, NASDAQ; the ultimate owner of the London futures market is now the New YorkStock Exchange The banks that dominate activity in the London markets are overwhelmingly foreign,particularly the Americans, Swiss, Germans, French and Japanese

It is best that we look at these changes before we examine in detail the workings of the UK

financial system Discussion of these changes requires an assumption of some knowledge on the part

of the reader as to how the system works However, this book is also designed to be read by thosewho know little of finance They may well want to start at Chapter 2 and return to the first chapterafter they have read the rest

The International Financial Revolution

In the past thirty years, the City has changed beyond recognition It has always been an important part

of the UK economy and a key source of overseas earnings, particularly in areas such as banking andinsurance

The City, or at least its financial markets, has always been powerful Many blame a ‘bankers’

ramp’ for forcing out the Labour government in 1931, and subsequent Labour governments ran intoproblems over sterling in 1948, 1967 and 1976 But now the financial markets’ influence seems all-pervasive Governments round the world find themselves constrained in their economic policies forfear of offending the markets James Carville, one of President Clinton’s key advisers, remarked that

he would like to be reincarnated as the bond market so he could ‘intimidate everybody’ When thefinancial system wobbles as it did in 2007 and 2008, the whole economy is threatened

In addition, a combination of lower tax rates and liberalized financial markets has widened incomedifferentials Many City employees earn as much in a year as normal people might hope to earn in alifetime, helping to force the prices of properties in London beyond the reach of teachers and nurses.All this has created a lot of resentment against ‘greedy’ bankers

Wider share ownership, encouraged by the government through privatizations and tax breaks, hascreated much greater interest in financial markets, reflected in greater coverage in newspapers and on

TV And, with governments round the world quailing in the face of the cost of state pension schemes,citizens are realizing that they may depend on the financial markets for their security in old age

Why has all this happened? In part, it is because of the breakdown of the financial system that

prevailed from the end of the Second World War until the early 1970s That system, generally known

as Bretton Woods, combined fixed exchange rates with strict controls on capital flows, so restrictingthe scope for financial market activity Under fixed exchange rates, currency speculation was onlyprofitable at occasional times, such as when Britain was forced to devalue sterling in 1967

Foreign-exchange controls also made it difficult for investors to buy equities outside their homemarkets That reduced the scope for share trading and ensured that the UK equity market was a

protected haven, dominated by small firms operating in a climate which author Philip Augar has

described as ‘gentlemanly capitalism’

But the system broke down in the early 1970s (for a full description see Chapter 14) The firstdomino to fall was fixed exchange rates The system had depended on the US dollar but that currencybuckled in the face of the costs of the Vietnam War

Once exchange rates began to float, two things started to happen First, companies faced exchange risk when selling goods For example, Mercedes’ costs were in Deutschmarks; when it sold

foreign-a cforeign-ar in the US, it received dollforeign-ars If the dollforeign-ar fell foreign-agforeign-ainst the Deutschmforeign-ark, thforeign-at would be bforeign-ad

news So companies looked for ways to protect themselves from these risks

Secondly, floating exchange rates created the potential for continuous speculation The 1970s sawthe creation of the financial futures market in Chicago, which allowed traders to bet on the likelymovement of exchange rates

Both developments were opportunities for financial companies They could make money

speculating on the markets and they could make money helping companies protect themselves fromforeign-exchange risk Both opportunities were taken

Floating exchange rates also had significant implications for governments Think of three key

elements of monetary policy: exchange rates, interest rates and capital controls Under the BrettonWoods system, countries controlled their exchange rates and capital flows However, if countries ran

a substantial trade deficit, capital would still flow out of the country

Take the UK, a country which habitually runs a trade deficit When a foreign company sells goods

to the UK, it receives sterling in return (Even if it asks for dollars, the UK buyer of the goods mustsell sterling and buy dollars in order to make the payment Sterling will still flow out of the country.)Eventually, those companies will become less and less willing to hold sterling at the prevailing

exchange rate The Bank of England may be willing to buy that sterling off the overseas companies but

it needs foreign-exchange reserves to do so After a while the money will run out

To avoid this problem, governments tried to cut the trade deficit The easiest way of doing so was

to raise interest rates; this had the effect of cutting consumer demand for foreign goods But the resultwas a stop– go kind of economy, in which periods of rapid expansion were suddenly cut short asgovernments raised interest rates to protect sterling

In a world of floating exchange rates, there is no requirement for governments to ratchet up interestrates every time the currency falls Voters naturally don’t like high interest rates The problem wasexacerbated by governments’ desire to keep unemployment low; at the slightest sign of economicweakness, they acted to boost the economy

So in the 1970s, governments let their currencies sag, and kept interest rates lower than they mighthave been The result (higher import prices, too much money chasing too few goods) was inflation

By the end of the 1970s, there was a general feeling that the old system of economic policy had failed.Governments had tried to micromanage the economy but in their attempts to keep down

unemployment, they had merely achieved stagflation: high inflation and unemployment Right-wingpoliticians such as Ronald Reagan and Margaret Thatcher argued that state intervention in industryhad stifled the economy, concentrating resources in sunset industries such as coal and steel, and

starving the growth sectors of the economy such as technology

Inflation was eventually brought to heel with the help of very high interest rates, which also

prompted massive job losses in those sunset industries This process caused much distress and

protest at the time and would have been politically impossible without the economic chaos of the1970s

At the same time (and to rather less fanfare), governments in the US and the UK relaxed the

regulations on the financial sector and abolished capital controls The idea was that the economywould function best when the markets, rather than bureaucrats, decided where to allocate capital

Suddenly, investors were free to invest anywhere in the globe Instead of concentrating on old UKstalwarts such as Imperial Chemical Industries or Marks & Spencer, they were free to invest in thelikes of Bayer of Germany or Wal-Mart of the US

These changes had enormous consequences for those who traded shares in the City The old systemhad been like a gentlemen’s club A group of people called jobbers did all the trading in shares Theywere not allowed to deal directly with investors Instead, a group of intermediaries called brokerslinked investors and jobbers, finding the best prices for the former in return for a fixed commission

In theory, this system protected the interests of investors Because brokers did not trade in shares,they could give independent advice to investors And because brokers could shop around, jobbershad to offer competitive prices

But there were two problems with this system The first was that it was clearly not a free market:jobbers and brokers were restricted in the roles they could play and commissions were fixed

Brokers could not compete on price

The second was that the broking and jobbing firms were all small This was fine in a world whereequity trading was limited to the home market But when investment became international, the

domestic firms were just too small to cope; they did not have the capital to deal with the risks

involved

BIG BANG

The solution was Big Bang: a set of sweeping changes that were implemented in 1986 The old

distinction between brokers and jobbers was abolished –firms could both act for investors and trade

in shares Outside capital was brought in, with UK, European and US banks buying up existing

broking and jobbing firms

A whole generation of senior brokers and jobbers retired on the proceeds of the sales and famousnames such as de Zoete & Bevan, or Akroyd & Smithers, either disappeared or were subsumed

within larger groups (The process is well described in The Death of Gentlemanly Capitalism by

Philip Augar, published by Penguin.) The old Stock Exchange floor, where brokers and jobbers metface to face, became a museum piece Now the bulk of the trading was done by telephone, with

investors kept constantly updated on share prices by brightly coloured Topic computer screens – withred signalling a falling price and blue, a rising one

The whole process brought benefits to institutional investors, since the abolition of fixed

commissions substantially cut their trading costs But it had its downsides as well One substantialproblem was that the integration of broking and trading created an automatic conflict of interest withinthe financial sector When a broker recommended a stock, was that because of a genuine opinion orbecause the trading arm of his firm had a large position in the shares? In recent years, a more

significant conflict of interest has arisen The abolition of fixed commissions has gradually ensuredthat commissions are only a small part of any bank’s revenues But, in theory, institutional investorsare supposed to reward analysts for their advice by placing trades with the firms concerned Thesums do not add up

Instead, banks have concentrated on increasing their revenues from transaction fees – acting forcorporations in issuing new shares or bonds and making takeovers This has led to analysts becoming

‘cheerleaders’ for such companies, talking up their prospects so that the deals will be successful Theidea of thoughtful, unbiased research has been severely compromised

The second problem that followed Big Bang was that control of equity trading moved out of thehands of UK institutions It was inevitable that control of part of the City would move overseas: the

US, European and Japanese banks all had a lot of capital But it seemed for a while as if the UK

could develop domestic champions One such was Barclays, which bought the broker de Zoete &Bevan, and the jobber Wedd Durlacher, and created BZW Another was S G Warburg, a successfulmerchant bank that bought brokers Rowe & Pitman, Mullens, and the jobber Akroyd & Smithers

Alas, most of the UK champions eventually dropped out of the race This development was

prompted by the next stage of the international financial revolution, which occurred during the 1990s

THE END OF THE COLD WAR

Free-market philosophy may have swept the board in the US and the UK during the 1980s but it wasnot so successful elsewhere Many observers believed that this so-called Anglo-Saxon model wasinferior to those developed elsewhere, particularly in Germany and Japan.

Both countries decided against giving the markets free rein In Germany, hostile corporate

takeovers were virtually unknown: companies had close relationships with their banks, which hadseats on the boards Maximizing returns to shareholders was not the priority it was in the Anglo-Saxon system; instead the interests of customers, suppliers and employees were taken into account

In Japan, takeovers were also unheard of Companies were protected against them by elaboratecross-shareholding with friendly groups Maximizing profits was seen as less important to Japanesemanagers than maximizing sales and market share

To their admirers, the German and Japanese systems seemed to offer many advantages The

absence of takeovers allowed companies to plan for the future, regardless of short-term profit

performance The result was higher investment And the focus on employees seemed far less sociallydivisive than the Anglo-Saxon model

Under the German–Japanese models, the freedom of financial markets played second fiddle toother factors That did not stop the Japanese stock market soaring to unprecedented heights in the late1980s

Of course, until the end of the Cold War, a large part of the world followed a communist or

socialist-style model, in which the financial markets played virtually no role at all

All this changed during the course of the 1990s The collapse of communism was clearly an

epochal event and appeared to underline the fact that there was no alternative to capitalism as aneconomic model Suddenly a whole raft of countries moved into the Western economic system,

adopting stock markets and allowing US companies like McDonald’s to open for business

The collapse of communism also led to the reunification of Germany The immense costs involved

in taking on the old East Germany led to the imposition of high interest rates by the Bundesbank, theGerman central bank, in an attempt to control inflationary pressures (This also eventually led to thebreak up of the Exchange Rate Mechanism.) By the mid-1990s, the German model no longer looked

so attractive German unemployment was far higher than that prevailing in the US German socialcosts were also far higher, prompting some German companies to site facilities overseas Germanpoliticians began to feel that high taxes were deterring entrepreneurship and causing sluggish

economic growth An ageing German population suggested that, in the long run, pension costs couldbecome a massive burden on the German state

So, slowly but surely, Germany and the rest of Europe started to edge towards the Anglo-Saxonmodel Businesses began to talk of ‘shareholder value’; they divested themselves of non-core

operations, simplified their shareholding structures and focused on improving profits Perhaps theultimate signal of the change in culture came in early 2000 when Mannesmann of Germany was takenover by Vodafone of the UK; this in a culture where hostile takeovers were extremely rare, let alone ahostile takeover by a foreign company

As Germany moved in an Anglo-Saxon direction, the attractions of the Japanese model also faded

In the late 1980s, Japan’s economy developed all the symptoms of a speculative bubble: share pricesrose to record levels in terms of profits or dividends while land prices also soared

The bubble popped in 1990 and some of Japan’s apparent virtues began to be revealed as vices.Companies did not worry about short-term profits, but this led them to invest in unsuitable projects.The absence of takeovers meant there was no market discipline on poor companies to perform well.The soaring stock market also led companies to indulge in speculation which proved ill-timed once

the market turned The friendly relationship between banks and the corporate sector meant that thebanks were saddled with bad loans, a problem that took more than a decade to sort.

Japan spent much of the 1990s stuck in a deflationary trap Despite a host of government spendingpackages and interest rates that eventually fell to zero, the Japanese authorities found no way of

reviving their economy

The problems of Japan caused an almost 180-degree turn in the commentaries of those writingabout economics and management In the late 1980s, bestselling books were written about how the USshould copy the Japanese; by the late 1990s, there was almost unanimous agreement on the need forall countries to copy the US

THE US ECONOMIC MIRACLE

The retreat from the German and Japanese models was not just about their perceived failures; it wasalso about the perceived success of the US

By the late 1990s, the US seemed by far the most dynamic of the world’s economies Growth

averaged more than 4 per cent a year, and that growth was achieved with barely a trace of inflation

At the same time, European economies struggled to grow at 2–3 per cent a year; the Japanese

economy struggled to grow at all Unemployment fell to 4–5 per cent, around half the level prevailing

in Europe There was, apparently, a productivity miracle (the figures were subsequently revised

down but still showed a substantial improvement over the 1980s)

In almost every growth industry – software, hardware, the internet, biotechnology, media – the USappeared to lead the world The US accordingly attracted floods of capital from overseas; both thedollar and the US stock market rose substantially

Economists attributed the US success to the openness of its economy, the lack of regulations, theuse of share options to motivate executives and employees, and a host of other ‘free-market’ factors.Understandably, countries trying to emulate the US example tended to adopt some of those measures

Free-market enthusiasts also pointed to the success of those Asian countries that had followed abroadly free-market view, such as Singapore, Hong Kong and Taiwan, and the failure of those

countries, notably in Africa, that had followed a statist or socialist model

A so-called ‘Washington consensus’ argued that any economy which wanted to prosper shouldfollow the free-market model: lower taxes, reduced government deficits and open capital markets.These policies were often made a condition for countries requiring aid from the International

Monetary Fund, the Washington-based organization that underpins the global financial system

The period since 2000 has seen the Washington consensus come under attack First, the US modellooks not quite as attractive as it did in the late 1990s The dotcom bubble burst in 2000 and then ahousing boom ended in a credit crunch in 2007 and 2008 Critics argue that the American financialfree-for-all leads to recurrent crises Meanwhile, emerging countries like China and Russia showed itwas possible to achieve rapid economic growth while still retaining a fair degree of governmentcontrol Having seen what the IMF could do to debtor countries, many developing nations focused onbuilding up trade surpluses, so they would not be dependent on foreign money Now it is the US

which is dependent on the Asians and the oil producers to finance its deficit Some argue that thisimbalance created the conditions for the credit crunch Americans used cheap money from abroad tospeculate on their property market

devastated British agriculture in the late nineteenth century.

In terms of trade and population movements, the world was pretty ‘globalized’ before the FirstWorld War; the subsequent battles with fascism and communism sent that process into reverse forsixty years

In two respects, however, globalization has surpassed the First World War system In terms ofinvestment, ownership of foreign assets peaked as a proportion of world GDP in 1900, at 18.6 percent By 1945, the proportion had dropped to 4.9 per cent Pre-First World War levels were finallyreached by 1980, at 17.7 per cent But since then there has been a massive acceleration; around athird of the UK stock market is owned by foreign investors, for example The big change has comewith the integration of the ex-communist world into the financial system Instead of being bit players,the likes of China, Russia and India are the key drivers of global economic growth They are blamedfor everything from driving up the prices of commodities to driving down the wages of workers in theWest Arguably, they were the main reason why inflation was so low in the 1990s and early 2000s asthey brought downward pressure on the prices of manufactured goods

In cultural terms, also, globalization is more powerful than ever before Clearly, before 1914,educated people in Europe and the US had a common culture based on the classics, orchestral music,opera and so on But the cinema, television and popular music mean that people from almost everycountry in the world will be able to recognize Tom Cruise, Bono or Madonna This is one factor thatcan cause great resentment, with some people feeling their culture is being swamped by Americanimports

THE UK’S ROLE IN THE FINANCIAL SYSTEM

What is the effect of globalization in the UK? The UK economy may have had its problems but theUK’s financial system has traditionally punched above its weight in global terms The leading

operators may well be US or European but they still choose London as their base Even though the

UK is not part of the Eurozone, European banks have not left en masse for Frankfurt, the financialcentre of the Eurozone and home of the European Central Bank

Some of this success as a financial centre is due to luck: the UK speaks the same language as the

US, the world’s leading economy and financial powerhouse US bankers feel more comfortable in anEnglish-speaking country; in addition, London seems a more attractive place to live than Frankfurt

Some of the success is due to the UK regulatory regime, which has consistently been fairly

welcoming to financial institutions The financial reforms of the Conservative administration of

1979–97, and the higher-rate tax cuts it introduced, have played their part The Labour government,which has been in office since 1997, has done little to reverse the trend

It is now generally accepted that the UK needs to offer an economy that is appealing to foreigninvestors and foreign companies The UK has been quite successful in attracting what is known as

‘direct investment’ from overseas companies: the building of factories, often in areas of high

unemployment in Wales, Scotland or the North East Politicians have argued that the UK has beensuccessful in this quest because the government has cut taxes on corporate profits and because ofmore flexible labour markets (a euphemism for saying that companies face fewer problems in firingworkers) Wider share ownership has also served the UK government’s purpose The cost of

providing state pensions is a great burden on European countries, with their ageing populations TheConservative government of 1979–97 cut this cost substantially, by linking future pension payments toprices rather than earnings But the effect after twenty years is that the state pension now provides apretty measly income

UK citizens have therefore come to realize that they will depend on their own savings for a decentretirement income Since shares have historically provided better returns than other assets, investorshave welcomed government schemes such as personal equity plans and individual savings accountswhich give tax breaks to savers They have also opted for personal pension schemes, which offer taxadvantages for long-term savers

All this has fuelled the growth of the institutional investors mentioned in the Introduction and hasmeant that the majority of Britons have some kind of interest in the stock market

But we have got ahead of ourselves Before we discuss these issues in more detail, it is time to goback to first principles

Money and Interest Rates

of how many sheep were worth a sack of corn

Gradually precious metals and, most notably, gold and silver were used as payment and becamethe first money Precious metals had several advantages Money had to be scarce It was no goodbasing a monetary system on the leaf Everyone would soon grab all the leaves around and the

smallest payment would require a wheelbarrowful Money also had to be easy to carry and in

divisible units – making the goat a poor monetary unit Gold and silver were sufficiently scarce andsufficiently portable to meet society’s requirements

Of course, it soon became inconvenient to carry gold and silver ingots Coins were created by thekings of Lydia in the eighth century BC From the days of Alexander the Great the custom began ofdepicting the head of the sovereign on coins

There are a variety of functions which money serves It is a measure of value Sheep can be

compared with goats and chalk with cheese by referring to the amount of money one would pay for

each product Money is also a store of value It can be saved until it is needed, unlike the goods it

buys, which are often perishable Creditors will accept money as a future payment, confident that itsvalue will remain stable in the meantime

Of course, today’s money is made from neither gold nor silver Coins are made from copper ornickel, and the most valuable monetary units are made of paper There are two main reasons for this.The first is that supplies of gold and silver were outstripped by the demands of society If money isscarce, it is difficult for the economy to expand and for us to get richer The second reason is the so-called Gresham’s Law that ‘bad money drives out good’ When money was in the form of gold coins,

it was tempting for those with a large number of coins to shave off a tiny fraction of each coin Theresulting shavings could be melted down to make new coins Gradually some coins contained lessgold than others Anyone who had a coin with the maximum amount of gold would have been foolish

to spend it lest he received a coin with less gold in return So the best coins were hoarded and theworst coins circulated Bad money drove out good

The earliest issues of money that was not backed by gold were known as fiduciary issues Money

is now totally divorced from its precious metal origins and seems unlikely to regress

Banknotes and Cheques

The next stages of the development of money – banknotes and cheques – are dealt with in Chapter 3,

on the banks It is sufficient to point out here that banknotes were, in origin, claims on gold and silver.Now money depends on the confidence of its users in the strength of the economy When economiesbreak down (as they occasionally do in wartime) money disappears and is replaced by some othercommodity such as cigarettes

As money has grown more sophisticated, so it has grown farther away from its origins Banknotesreplaced coins Cheques replaced banknotes Now debit and credit cards have taken the place ofcheques, and many people use debit cards rather than cash for shopping

The system depends on the confidence of all those concerned Shopkeepers accept credit cardsbecause banks will honour them; utility companies accept cheques as payment for gas and electricitybills Bank accounts are therefore money in the same sense as notes and coins are, since they can beused instantly to purchase goods

Banks can thus create money This is because only a small proportion of the deposits they hold isneeded to meet the claims of those who want to withdraw cash Much of the need is met by those whodeposit cash A simple way for a bank to lend money is to create a deposit (or account) in someone’sfavour

Suppose that a country has only one bank, which finds that it needs to keep 20 per cent of its

deposits in the form of cash It receives an extra £200 worth of cash deposits The bank then buys

£160 of BT shares, leaving £40 cash free to meet any claims from depositors The person from whom

it bought the shares now has £160 in cash, which is deposited with the bank So the bank has £360 indeposits (the original £200 plus the new deposit of £160), of which it needs to keep only £72 (20 percent) in the form of cash The bank is therefore able to increase its total investments to £288 (£360 –

£72) and can buy a further £128 of BT shares Once again the person from whom it buys the shareswill receive cash, depositing this with the bank This process will continue until the bank has

deposits of £1,000, of which £200 is held in the form of cash The bank’s balance sheet will then looklike this:

ASSETS LIABILITIES

Cash £200 Customer deposits £1,000

BT shares £800

TOTAL £1,000 £1,000

(Note that customer deposits are a liability, since they might at any time have to be repaid.)

To find out the total amounts of deposits that can be created from the original cash base, divide 100

by the percentage which the bank needs to hold as cash (known as the cash ratio) Then multiply the

result by the amount of the original deposit Thus, in this example, dividing 100 by the cash ratio of

20 per cent gives 5, and multiplying that by the original deposit equals £1,000

The cash ratio is therefore very important If, in the example, the ratio had been only 10 per cent,the amount of deposits created from the original deposit would have been £2,000 and not £1,000 Inpractice, banks find that they need to keep around 8 per cent of their deposits in the form of liquidassets

This relation between the money which banks need to hold in liquid form and the amount whichthey can lend has, in the past, been used by the Bank of England to control the level of credit in theeconomy (see Chapter 5)

Defining the Money Supply

As money has become increasingly sophisticated, so it has become more and more difficult to defineexactly what it is This issue assumed particular importance with the prominence of the monetaristschool of economics, which believed that the level of inflation is closely related to the rate of

increase of the money supply In the late 1970s and early 1980s many Western governments, includingthe UK’s, were strong adherents of the monetarist school and attempted to base economic policies onits theories Accordingly, they needed to define the money supply before they could control it

This proved to be difficult; Professor Charles Goodhart of the London School of Economics

remarked that any measure of money supply would misbehave as soon as it became used as a policyguideline The financial sector is constantly finding new instruments and ways of lending money As aresult, the Bank of England has published several definitions of money over the years But with themoney supply data less crucial to the formation of economic policy, it now focuses on just two –narrow money, broadly defined as notes and coins in circulation with the public and broad money,known as M4 The latter largely consists of lending by UK banks and building societies to the privatesector

to £322.10 at the end of the five-year period This interest rate is essentially the price of money The

price is paid by the borrower in return for the use of the lender’s money The lender is compensated

for not having the use of his money.

There are two alternative methods of calculating interest: simple and compound.

Simple interest can be easily explained If a deposit of £100 is placed in a building society and

simple interest of 10 per cent per annum is paid, then after one year the deposit will be £110, aftertwo years £120 and so on Nearly all interest is paid, however, on a compound basis

Compound interest involves the payment of interest on previous interest In the above example the

depositor would still receive £10 interest in the first year In the second year, however, interest

would be calculated on £110, rather than on £100 The depositor would thus earn £11 interest in thesecond year, bringing his deposit to £121 In the third year he would earn £12.10 interest and so on.The cumulative effect is impressive The same £100 deposit would become £350 after twenty-fiveyears of simple interest but £1,083.50 with compound interest Most savings accounts operate on theprinciple of compound interest, but most securities pay only simple interest A bond may pay 5 percent a year but only on the principal amount borrowed That amount does not increase over the bond’slifetime

When dealing with a bond or with a share, it is more important to talk of the yield than merely of

the interest rate or dividend.

interest rate or dividend will be more or less significant as the price falls or rises The interest rate or

dividend, expressed as a percentage of the price of the asset, is the yield A security with a price of

£80 that pays interest of £8 a year has a yield of 10 per cent If the value of the security rises to £100,the yield will fall to 8 per cent In assessing the profitability of various assets, calculating their yield

is very important; articles in the financial press will talk about equity yields and bond yields as much

as about dividends and interest rates

Until the 1950s, the yield on shares was higher than that on most bonds, since shares were

perceived as a riskier form of investment Since then, shares have offered lower yields than bonds orsavings accounts because the prospects of capital growth are much greater That changed in the case

of the credit crunch as share prices plummeted It is too early to tell whether it is the start of a newera

Probably the best way of showing the importance of yields is to cite the bond market Suppose that

in a year of low interest rates the Jupiter Corporation issues a bond with a face value of £100 and aninterest rate (normally called the coupon) of 5 per cent In the following year interest rates rise andbond investors demand a return of 10 per cent from newly issued bonds Those investors who boughtJupiter bonds are now stuck with bonds which give them only half the market rate Many of them willtherefore sell their Jupiter bonds and buy newly issued bonds

Who will they sell the bonds to? Potential buyers of Jupiter bonds will be no more willing to

accept a yield of only 5 per cent than the sellers Bond sellers will therefore have to accept a reducedprice for the Jupiter bonds The price will have to fall until the returns from Jupiter and other bondsare roughly equal If the bond price fell from £100 to £50, then each year bondholders would stillreceive £5 on a bond which cost them £50 – a return, or yield, of 10 per cent The Jupiter bond would

be as attractive as a bond priced at £100 with a 10 per cent coupon, which would also yield 10 percent

Calculating the yield on a bond is not quite that easy, however The bond will be repaid at somefuture point Say, for example, it has a nominal value of £100, sells for £96, pays £5 interest a yearand has one year to go before it is repaid Over the next year the bondholder will receive £5 interestand £4 capital – the difference between the £96 it sells for and the £100 which will be repaid So thebond yields £9 on a price of £96, just under 10 per cent A yield which is calculated to allow for

capital repayment is called the gross yield to redemption Going back to the Jupiter issue, the bonds

would not have to fall in price as low as £50 to keep their yields in line If they had a five-year

maturity, they would have to fall only to around £83 to have a gross yield to redemption of about 10per cent Bond trading depends on quick and sophisticated calculation of yields and exploitation of

anomalies in the market.

This process of adjusting prices to bring yields in line gives bond investors the prospect of capitalgain (or loss) on their holdings An investor who buys Jupiter bonds at £100 would lose £25 if theprice fell to £75 because of the yield adjustment That would more than wipe out any interest earned

on the bond However, if the interest rate offered on other bonds fell back to 5 per cent again, thenJupiter’s bonds would climb back to their face value of £100 An investor who bought at the low of

£75 would have made a capital gain of 33 per cent and still earned interest in the process

Because of the yield factor, bond prices have an inverse relationship with interest rates: bond

markets are generally euphoric when interest rates are falling, depressed when they are rising

INTEREST-RATE DETERMINANTS

Having understood the difference between simple and compound interest and the importance of

yields, we can now look at the factors that determine an interest rate In fact, it is more correct to talk

of interest rates At any one time a host of different rates are charged throughout the economy So it is

important to distinguish the determinants of specific interest rates as well as those which affect thegeneral level of rates in the economy

First, let us look at the determinants of specific rates One of the principal elements is risk There

is always the chance, whomever money is lent to, that it will not be repaid That risk will be reflected

in a higher interest rate This is one of the general principles of finance The riskier the investment,the higher the return demanded by the investor It is a principle which sometimes is ignored, mainlybecause investors do not always assess risk adequately Nevertheless, it is a useful principle to bear

in mind, especially when it is stood on its head Those investors who seek extremely high returnswould be wise to remember that such investments normally involve extremely high risk

Governments are usually presumed to be the least risky debtors of all, at least by lenders in theirown country (Other countries’ governments are a different matter, as many banks who lent to Braziland Argentina in the 1970s discovered.) But the government of a lender’s country can always printmore money to repay the debt if necessary In any case, if the government does not repay debt, it isreasonable for investors to presume that no one else in the country will

Banks were traditionally rated next on the credit ladder Nowadays, however, many large

corporations are considered better credit risks than even the biggest banks For the benefit of

potential investors, some agencies have devised elaborate rating systems to assess the

credit-worthiness of banks and corporations (see Chapter 11)

At the bottom of the ratings come individuals like you and me Individuals have a sad tendency tolose jobs, get sick, overcommit themselves and default on their loans Unless they are exceptionallywealthy, individuals thus pay the highest interest rates of all

One of the other main elements involved is liquidity The house buyer with a mortgage has to pay ahigher rate than is received by the building society depositor because the society needs to be

compensated for the loss of liquidity involved in tying up its money for twenty-five years The societyfaces the risk that it will at some point need the funds that it has lent to the house buyer but will beunable to gain access to them As I mentioned in the Introduction, this is another of the basic

principles of finance The more liquid the asset, the lower the return The most liquid asset of all,cash, bears no interest at all

Logical though the above arguments are, it often happens that long-term interest rates are belowshort-term rates To understand why, we must look at the yield curve.

The Yield Curve

We have already proposed a general principle of finance – that lesser liquidity demands greater

reward That being the case, longer-term instruments should always bear a higher interest rate thanshort-term ones This is not always true Long-term rates can be the same as, or lower than, those ofshort-term instruments

A curve can be drawn which links the different levels of rates with the different maturities of debt

If long-term rates are above short-term ones, this is described as a positive or upward-sloping yield curve If short-term rates are higher, the curve is described as negative or inverted.

What determines the shape of the yield curve? The three main theories used to explain its structureare the liquidity theory, the expectations theory and the market-segmentation theory

The liquidity theory, which has already been outlined, states simply that investors will demand an

extra reward (in the form of a higher interest rate) for investing their money for a long period Theymay do so because they fear that they will need the funds suddenly but will be unable to obtain them,

or they may be worried about the possibility of default Borrowers (in particular, businesses) will beprepared to pay higher interest rates in order to secure long-term funds for investment Thus, otherthings being equal, the yield curve will be upward-sloping

The expectations theory holds that the yield curve represents investors’ views on the likely future

movement of short-term interest rates If one-year interest rates are 10 per cent and an investor

expects them to rise to 12 per cent in a year’s time, he will be unwilling to accept 10 per cent on atwo-year loan It would be more profitable for him to lend for one year and then re-lend his money atthe higher rate A two-year loan will therefore have to offer at least 11 per cent a year before the

investor will be attracted Thus if interest rates are expected to rise, the yield curve will be

upward-sloping If investors expect short-term interest rates to fall, however, they will seek to lend

long-term That will increase the supply of long-term funds and bring down their price (i.e long-term

interest rates) Thus the yield curve will be downward-sloping.

What determines investors’ expectations of future interest-rate movements? Much may depend onfuture inflation rates If inflation is set to rise, then price rises will absorb much of an investor’s

interest income So investors will demand higher rates when they think inflation is set to increase.The economist John Maynard Keynes constructed a more elaborate theory which depended on theyield of securities If people expect interest rates to rise, Keynes argued, they will hold on to theirmoney in the form of cash, in order to avoid capital loss But if they expect rates to fall, they willinvest their money to profit from capital gains Of course, this principle applies to bonds rather than

to interest-bearing accounts As we have seen, if interest rates rise, the price of previously issuedbonds falls until investors earn a similar yield from equivalent bonds Thus a bond investor who

expected rates to rise will sell his bonds before the rise in rates and the resultant fall in the bondprice occurs The investor will hold the funds in the most liquid form available so that he can reinvestthem as soon as rates rise If the same investor expects interest rates to fall, he will hold on to thebonds because their price will rise as rates fall

The third theory of the yield curve is the market-segmentation theory This assumes that the

markets for the different maturities of debt instruments are entirely separate Within each segmentinterest rates are set by supply and demand The shape of the yield curve will be determined by thedifferent results of supply/demand trade-offs If a lot of borrowers have long-term financing needsand few investors want to lend for such periods, the curve will be upward-sloping If borrowersdemand short-term funds and investors prefer to lend for longer periods, the curve will be

downward-sloping

Economic Theories on the General Level of Interest Rates

We have already looked at the factors which affect the level of interest rates for different maturities,instruments and borrowers It is also worth considering theories which concern the general level ofrates in the economy

As already mentioned, the rate of inflation is generally accepted to be a substantial ingredient ofinterest rates Lenders normally expect interest rates at least to compensate them for the effect of

rising prices They therefore watch closely the real interest rate – that is, the interest received after

inflation has been taken into account Historically, real interest rates have averaged around 2–3 percent; that is, if inflation were 7 per cent, interest rates would be 9–10 per cent However, this

relationship is far from permanent: real interest rates have been, at times, negative (below the rate ofinflation), and at times in the 1980s they were as high as 8 per cent, making that a very good time tolend

The most important inflation rate is the rate which a lender expects to occur during the lifetime of

his or her investment The inflation rate which is published by the government, the consumer price

index, gives only the previous year’s price rises, but it is next year’s price rises which will affect the

value of the lender’s investment So lenders must undertake a difficult piece of economic forecasting

It is very important to remember that financial markets are now international Rates in Britain

cannot be separated from those in other countries UK investors can invest abroad if there is the

chance for higher rates overseas, and foreign investors can invest here if UK rates are above theirown Both decisions are linked with the level of exchange rates An investment in the US might yield

a high dollar rate of return, but if the dollar fell against sterling, investors would find themselvesworse off

Governments concerned about the level of interest rates will often intervene to try to influence theirmovement They may be concerned about the exchange rate and may push interest rates up to defendthe pound Alternatively, they may be concerned about the amount of credit in the economy Peoplemay be borrowing because interest rates are low, with the result that excessive demand is leading toinflationary pressures

The classical explanation of the level of interest rates is associated with the theory of supply anddemand Thus the interest rate is the balancing point between the flow of funds from savers and theneed for investment funds from business If more funds become available from savers, or if industryhas less need to borrow, interest rates will fall If the funds available from savers are reduced, or ifindustry has a greater need to borrow, interest rates will rise The demand for funds is likely to beaffected by business people’s expectations of future profits If they believe that they will achieve a

high rate of return on investment, they will be willing to borrow.

The supply of funds for borrowers depends largely on the willingness of the personal sector tosave Why do people save? One of the main reasons is to provide for old age or for children andspouses in the event of early death This form of saving normally takes the form of investment in

pension funds and life assurance and is helped by tax advantages There has been a substantial growth

in this form of saving since the 1960s Another reason is to guard against rainy days caused by illness

or unemployment: by its nature, such saving needs to be very liquid and is normally placed in

building societies or interest-bearing bank accounts A third reason for saving is to allow for majorpurchases or for holidays: again, such savings need a liquid home like a building society account

Just as important as the reasons why people save are the reasons why the proportion of their

income that they save changes over time A certain amount of wealth is necessary before people cansave – if all of someone’s income is needed just to pay for food and rent, there will be no money left

to save However, it is not correct to assume the reverse: that the larger a person’s income, the more

he or she saves The highest income-earners are often among the biggest borrowers, since banks will

extend credit only to those who they think will be able to repay The greater a person’s income,

therefore, the greater the possibility for incurring debt Debt is negative saving In fact, the cautiousmiddle classes have traditionally been the biggest savers

However, academic explanations of movements in the savings ratio (the proportion of incomewhich is saved) have focused on income levels If income rises, according to theory, there will be alarger increase in the level of savings; if income falls, savings will drop disproportionately as peoplerun down their incomes to pay for their expenditure

During the inflationary 1970s the savings ratio increased sharply, much to most economists’

surprise Since inflation erodes the purchasing power of savings, it was assumed that consumers

would run down their cash balances and deposits, which bear a negative real interest rate, and wouldprefer to hold physical assets such as property, the value of which tends to increase in line with

inflation

What seems to have happened instead is that savers, perhaps for the rainy-day reasons outlinedabove, were concerned to maintain the purchasing power of their savings Because of the rate ofinflation, they needed to save a greater proportion of their income merely to keep the value of theirsavings constant The rise in the savings ratio in the 1970s was followed by an equally sharp decline

in the 1980s as inflation fell and it became easier to maintain the value of savings

Saving seems to have a clear correlation to the state of the economy In times of boom, people tend

to save less They are more confident about their job prospects and are happy to borrow money tomake expensive purchases, such as cars and durable goods In times of economic slowdown, they cutback their expenditure because they are less confident about their job prospects

In analysing savings patterns an important distinction to recognize is that between committed anddiscretionary savings Committed savings are made up of contributions to life assurance and pensionsschemes and, as such, are relatively inflexible to changes in income Discretionary savings representpayments into building society accounts or perhaps unit trusts Such savings adjust much more quickly

to income movements Repayment of a mortgage represents committed savings in that it is an

investment in the value of a real asset (i.e a house)

Indeed, many believe that the housing market has distorted UK savings patterns Years of inflation,and the favourable tax treatment of home ownership, has taught British investors that property is thesafest store of wealth

What does seem clear is that the greater sophistication of the modern financial system causes

interest rates to move more frequently than ever before.

The Retail Banks and Building Societies

Banks are at the heart of the financial system They are the one type of financial institution with whichall of us are bound to come into contact at some point in our lives When they falter, as they did in

2007 and 2008, governments feel obliged to come to their rescue since, without them, the economycould not function

Like banks, building societies take deposits from individuals and lend them to others Over the lasttwenty years or so, many societies have either turned into, or been acquired by, banks So whereas inprevious editions they merited a separate chapter, they now need to be treated as part of the bankingindustry

THE FIRST BANKERS

Gold and silver have traditionally been the two predominant monetary metals for the reasons outlined

in Chapter 2 As a result, goldsmiths and silversmiths became the earliest bankers Nervous citizens,who were well aware of the dangers of keeping their gold under the mattress, began to use the smiths,who had safes to store their wares, as a place to keep their wealth In return, the smiths would givethe depositor a handwritten receipt It soon became easier for the depositors to pay their creditorswith the smiths’ receipts, rather than go through the time-consuming process of recovering the gold orsilver and giving it to the creditor, who might only re-deposit it with the smith Creditors were

willing to accept the receipts as payment, provided that they were sure that they could always redeemthe receipts for gold or silver when necessary

The receipts were the first banknotes The legacy of those early receipts is visible today in theform of the confident statement on banknotes: ‘I promise to pay the bearer on demand the sum of …’

Despite having the image of the Queen to back it up, that statement is of no value today and anyoneattempting to redeem a five pound note for gold at his local bank will be disappointed

Smart goldsmiths were able to take the development of banking one stage further They noticed that,

of the gold stored in their safes, only a small quantity was ever required for withdrawal and that

amount was roughly matched by fresh deposits There was therefore a substantial quantity of moneysitting idle The money could be lent (and interest earned) in the knowledge that the day-to-day

requirements of depositors could still easily be covered (see Chapter 2)

The Italian Influence

Among the earliest bankers were goldsmiths and silversmiths from the Lombardy region of Italy whowere granted land in London by King Edward I One of the sites they received – Lombard Street – is

at the heart of the modern City of London Back in Italy, the money lenders had conducted their

business from wooden benches in market places The Italian word for bench, banco, was corrupted

by the English into ‘bank’ The Italians were also responsible for introducing the symbols that were

synonymous with British money until 1971 – £, s and d., or lire, solidi and denarii It is a nice irony

that those who wear the £ symbol as a signal of opposition to Europe are in fact displaying an Italianfigure

Many of the early bankers misjudged their ability to absorb ‘runs’– times of financial panic wheninvestors rushed to claim back their gold In such cases, bankers had insufficient funds to meet theclaims of depositors upon them and thus became ‘bankrupt’ (literally ‘broken bench’) Such runscould easily become self-fulfilling As soon as depositors feared that a bank might become bankrupt,they would flock to the banks in order to demand their money back, thus accelerating the bank’s

deterioration into ruin Because of the nature of banking, no bank could stand a determined run Sometried ingenious methods to do so One bank arranged for a few wealthy depositors to arrive by

carriage at the front of the bank and withdraw their gold ostentatiously The queuing small depositorswere impressed Meanwhile, the wealthy depositors sent their footmen round the back to re-depositthe gold, so it could be used to meet the claims of the other depositors

Bankruptcies did not reduce the total number of banks The seeming ease with which it was

possible to make money from banking soon attracted others to take the places of the institutions thathad failed Gradually, depositors regained confidence in the trustworthiness of the banks Thus began

a regular banking cycle of boom and bust Professor Galbraith explained that the length of these

cycles ‘came to accord roughly with the time it took people to forget the last disaster – for the

financial geniuses of one generation to die in disrepute and be replaced by new craftsmen who thegullible and the gulled could believe had, this time but truly, the Midas touch’

In the UK Charles I, that unlikely saint, gave banking an unwitting boost in 1640 by seizing

£130,000, which merchants had unwisely committed to his safe-keeping by placing it in the RoyalMint Merchants decided that in future it would be rather safer to deposit their funds with the bankers

in the City It was not until 1694 that the government’s financial reputation could be restored and theBank of England established: by that time, the crown was on the head of the sober and respectableDutchman, William of Orange

The banks which most people know, and are indeed at the heart of the UK financial system, are theclearing banks, so called because individual transactions between them are cleared through the

London Clearing House system This saves the banks, and therefore their customers, a lot of time.Rather than have Lloyds pay over £20 to Barclays for Mr Brown’s gas bill and Barclays pay £15 toHSBC for Mrs Smith’s shopping, the clearing house tots up all the individual transactions and arriveswith a net position for each bank at the end of the day Lloyds might owe Royal Bank of Scotland

£20,000 and HSBC owe Barclays £15,000 – the important fact is that on a daily basis, each bank is

involved in only one clearing house transaction with any other.

Chaps

In 1984, the clearing process was much improved by the introduction of the Clearing House

Automated Payment System (CHAPS), which replaced the old manual system for processing chequesand bankers’ payments Rather than laboriously adding up the total of each bank’s payments and

receipts by hand, a CHAPS payment results in an adjustment to a running total held on the system At

the end of the day, each bank has logged up a deficit or surplus vis-à-vis the other banks in the system.

Payments are cleared in a few minutes rather than the hour and a half of the old system

The work that the clearing banks handle is huge In 2004, CHAPS was handling an average of

130,000 payments worth £300 billion each day, up from just 7,000 transactions worth £5 billionwhen it first started And CHAPS is part of the Target system designed to settle deals across the

European Union

Twenty years ago, there were four big banks – Barclays, Lloyds, Midland and National

Westminster That pattern has changed significantly thanks to takeovers and the conversion of buildingsocieties into banks Some banks are still recognizable For example, Lloyds acquired the TrusteeSavings Bank and became Lloyds TSB; it then bought the building society Cheltenham & Gloucesterand the life insurance firm Scottish Widows In 2008, in the midst of the financial crisis, it boughtHBOS, the bank that combined the old Halifax building society with the Bank of Scotland The dealwas disastrous for shareholders and the government ended up owning a majority stake But after allthese changes, Lloyds still uses the black horse logo and is largely a retail bank

Barclays Bank has had a mixed record in investment banking, building up a group known as BZWand then slimming it down to Barclays Capital before taking advantage of the financial crisis to buythe US operations of Lehman Brothers The bank has been extremely successful in fund managementwhere, as Barclays Global Investors, it is one of the biggest investors in the world, with a particularexpertise in tracking stock market indices

Midland Bank has long since lost its independence, agreeing to a takeover by the Hong Kong andShanghai Banking Corporation (HSBC) in 1992 The Midland brand name was duly phased out

NatWest was acquired by the Royal Bank of Scotland in 2000, after a fierce bidding battle, but stilltrades under its original name on the high street RBS went on to buy ABN Amro of the Netherlands, aterrible deal that ended up forcing the government to rescue the bank

Another big British banking presence is the Spanish Grupo Santander which acquired the formerbuilding societies Abbey National in 2004 and Alliance & Leicester (along with the savings accounts

of Bradford & Bingley) in 2008

Relative to the big American banks, such as Citigroup, or continental European banks like

Deutsche or Union Bank of Switzerland, the British banks are not as big players in investment banking(although both HSBC and Barclays have respectable operations) That is a pity to those who wouldlike to see a national champion in every industry

But the problem with the all-singing, all-dancing bank is that every few years they tend to hit a flatnote or trip over their own feet The solid commercial bankers start to resent the flashy, highly-paidinvestment bankers who tend to lurch from one disaster to another The concept is thus highly

expensive and very risky Mind you, the commercial banks have managed to have plenty of disasters

in the theoretically safer area of domestic personal and corporate banking

The Importance of Retail Deposits

The retail banks long had a built-in advantage – the current accounts of ordinary depositors like youand me Such accounts traditionally paid no interest whereas the banks could charge as much as 20per cent on overdrafts – a fairly hefty profit margin Banks without retail deposits have to borrow atmarket rates in the money market in order to obtain funds It can be said in justification of the retailbanks that the costs of such a large network of branches, in terms of buildings, staff and paperwork,take a substantial slice of that margin

This so-called endowment effect started to disappear in the 1980s when competition from buildingsocieties forced the banks to offer interest-bearing accounts In the late 1990s, retail deposits started

to look as much of a burden as a boon The problem was that servicing those depositors required themaintenance of a vast and expensive branch network

Rivals emerged with the ability to ‘cherry pick’ the best retail customers One group was the

supermarkets, which offered interest-bearing accounts to their customers Another was internet banks,such as Egg, which were able to offer interest-bearing accounts without the need for branch networks.The big banks reacted by cutting costs, laying off staff and closing banks in rural areas and smalltowns They also encouraged investors to switch to banking over the telephone or the internet, andfocused on other higher-margin products such as life insurance and fund management

But internet banking has created a new class of ‘rate tarts’, investors who will take the highest rate

on offer but will switch as soon as another more attactive deal comes along This has allowed

overseas banks, such as ING of the Netherlands and Landesbanki of Iceland, to win market share(when the latter went bust in 2008, 300,000 British savers were affected) As a result, deposits areless ‘sticky’ than they used to be – in other words, banks cannot be sure of hanging on to them Thishas caused some banks to depend more on the wholesale, or money, markets for funding, with

important consequences

Banks and the Subprime Crisis

Over the last decade or so, there has been a global move away from depending on retail deposits and

to what is known as an ‘originate and distribute’ model Banks raise money from other institutions inthe wholesale markets They still make loans – to individuals, companies and so on – but they do nothang on to them They bundle them up into pools of assets and sell them to outside investors

Why does this occur? From a bank’s point of view, the approach is attractive because of

regulations Under the Basel international accords, they were required to set aside reserves for

certain loans on their balance sheets These reserves must be held in the form of low-yielding assetssuch as government bonds The more reserves a bank has, the lower its profits are likely to be Thusthere is an incentive for the bank to get those loans off its balance sheet by selling them, provided it

can still earn some sort of fee income from making the loan in the first place.

Why would anyone want to buy such loans? Low inflation in the 1990s and 2000s drove the yields

on government bonds down to very low levels This made investors desperate for assets offeringhigher returns Asset-backed securities, as they became known, offered such returns They might bepools of mortgages, car loans or credit cards In theory, because the pools were diversified, the

losses would be predictable This process of securitization has been going on for thirty years or sobut it took off amazingly quickly in the early part of this century

Credit booms tend to be self-reinforcing Say the average house price is £100,000 and banks arewilling to lend 80 per cent of the home value The average homeowner puts down a deposit of

£20,000, borrows £80,000 and buys the house Prices rise by 20 per cent, so the average home isnow worth £120,000 Homeowners are better off and banks are now feeling better about lending tothem; after all, the value of their collateral has gone up So they now figure they can lend against 90per cent of a house’s value Now potential homeowners only need £12,000 for a deposit So therewill be more potential buyers, which will push house prices up further, making banks more confidentabout lending and so on

This is what happened in the early years of this century in America and to a lesser extent in Britain

As house prices rose, lending standards were relaxed Securitization speeded this process After all,

if you were going to sell the loan within a few months, why worry about whether the borrower would

be able to repay in a few years’ time? And why would borrowers worry about repaying if they

expected to sell the house for a quick profit?

In the US, the extreme part of the process was so-called ‘liar loans’ which were made to

borrowers who had to provide no proof of their income Of course, such loans carried higher rates ofinterest, but they were not high enough Some of these borrowers were ‘Ninjas’, a term indicatingthey had no job, no income and no assets

All was well while house prices were going up But as soon as they started to falter, it becameclear that many borrowers could not afford to keep up the interest payments Indeed, once it becameclear that house prices were falling, some walked away without making any payments at all Thebonds backed by these mortgages, known as subprime in the jargon because of the low credit ratings

of the borrowers, started to default

But what made the crisis worse was that the mortgage-backed bonds themselves had been bundled

up and repackaged Securities known as collateralized debt obligations or CDOs had been created.These were made up of bundles of asset-backed bonds

The CDOs were sliced and diced into different elements, known as tranches The riskiest slice,known as equity, paid the highest yield But in return, they suffered the first loss when any of the

underlying assets defaulted The higher tiers in the pyramid carried less risk but paid a lower yield.The top tier of all, often known as supersenior, was in theory extremely safe

There were lots of problems, however, with this structure One was the tiering of risk Portfolioswere assembled that comprised the riskiest parts of mortgage-backed securities As a result, whenthey were pooled together in CDOs, risks were concentrated, not diversified; if one part of the

portfolio was likely to default, so was the rest This meant the more senior parts of the portfolio weremore risky than the owners had thought

This problem was compounded by the use of borrowed money, or leverage As already explained,supersenior tranches offered fairly low yields This made them unexciting investments But if youcould borrow money for less than the yield on the supersenior, this made them potentially a lot moreenticing And the regulations that governed the level of bank capital did indeed make this an attractive

option, on the assumption that the bonds would never default.

Alas, when the scale of the subprime crisis became apparent, the prices of these securities fell andbanks were forced to reveal their losses The problem was made worse by the existence of specialistvehicles such as conduits and structured investment vehicles (SIVs) These, like the banks, had usedborrowed money to invest in mortgage-backed securities and CDOs In fact, they had borrowed themoney from the banks In some cases, they were unable to repay their loans; in others, the vehicleswere clearly creatures of individual banks, and the banks were forced to rescue them

Britain was not immune from this problem, even though it originated in the US In part, this wasbecause some of the banks had invested in the complex CDOs that proved so difficult to value whenthe housing market turned down But it was also because British banks had moved to the originate anddistribute model When the credit crunch hit, some of those banks were particularly vulnerable

The Northern Rock Collapse

Building up a base of retail deposits takes time and resources Either you need a big base of branches(with lots of costly property and staff), a call centre to handle consumer enquiries or you need to offer

a high return to attract the rate tarts who surf the internet

The originate and distribute model seemed to offer a quicker and easier route to gain market share.Instead of waiting for deposits to build up, a bank could go out and make the mortgage loans it

desired and then sell those loans in the financial markets Provided it received a higher rate fromhomeowners than it paid in the market, such a strategy would be profitable

Northern Rock, a Newcastle building society turned bank, was the British institution that provedmost aggressive in pursuing this strategy By 2007, it was Britain’s fifth biggest mortgage providereven though it had just 76 branches When it ran into trouble, only a quarter of its funds came fromretail customers

The strategy had enabled Northern Rock to expand very quickly; in the first half of 2007, its

lending was 31 per cent higher than the year before This approach looked highly profitable

Ironically enough, the last annual results that it produced before its collapse showed record pre-taxprofits of £627 million, 27 per cent higher than the previous year Indeed, anyone who looked at theraw data might have been surprised by Northern Rock’s collapse; the repayment arrears on its

mortgages were less than half the industry average

But these headline numbers belied some fundamental weaknesses It takes time for mortgages to gowrong and when it got into trouble, a third of Northern Rock’s loans were less than two years old As

it expanded, it was increasing the proportion of loans to homebuyers with a small deposit (and tothose who wanted to borrow more than the value of the house itself) It was also heavily involved inthe buy-to-let market Investors were well aware that it might be vulnerable if house prices fell; itsshare price was declining steadily from the spring of 2007

The bank had also made one fatal assumption; that the money markets would always be open to it.But in August 2007, alarmed by losses on subprime loans, investors suddenly wanted nothing to dowith mortgage-backed securities Northern Rock had raised money from the markets in January andMay, and was scheduled to do so in September In August, it was thus low in cash It had not thought

to put emergency funding plans in place

So the bank had to turn to others for help An attempt was made to sell the bank to Lloyds TSB butLloyds wanted a £30 billion loan from the Bank of England before it would sign the deal The centralbank was unwilling to agree; ironically, its eventual exposure to Northern Rock proved much larger.The only option left was direct help from the Bank of England, and when news of that deal leaked,retail customers started to demand their money back What emerged was a classic ‘run on the bank’such has been seen many times in history.

Even without the run, Northern Rock was probably finished as an independent entity But the runruined Northern Rock’s brand name, making it more difficult to sell the bank to a private company.Eventually, it had to be nationalized And the run on the bank caused the authorities to worry thatother banks might be threatened; Alistair Darling, the chancellor, was forced into making the

extraordinary pledge of guaranteeing, not just Northern Rock’s deposits, but those of any other bankthat got into trouble

Order was eventually restored with the help of a change to the deposit insurance scheme, that

guaranteed the first £35,000 of all deposits (in 2008, this had to be increased to £50,000) But thewhole affair dented confidence in Britain’s financial system When the credit crunch bit again in

2008, worries about the dependence of HBOS on the wholesale markets forced it into the arms ofLloyds TSB, and Bradford & Bingley was closed by the government

These measures only seemed to exacerbate the crisis, by decreasing investor confidence in thebanking system It became either impossible or very expensive for banks to get finance from the

wholesale markets In turn, that made them more cautious about lending to companies and consumers.The crisis reached such a peak that, in October 2008, the government was forced to unveil a massive

£400 billion rescue scheme that involved buying bank shares, guaranteeing their loans and lendingthem money to tide them over until the markets resumed normal trading

The effective nationalization of parts of the banking industry raised some difficult questions

Should the government control the pay of individual bankers? And should it direct where banks maketheir loans?

Assets and Liabilities

The demise of Northern Rock illustrated one of the perennial weaknesses of banks; they borrow shortand lend long In other words, if people lose confidence in the banks, they can get in trouble veryquickly

Understanding bank finances requires a good grip on the terminology and this can be a little

counter-intuitive The monies we hold in our current accounts are not the assets of the banks; they aretheir liabilities since we can ask for them back at any moment

Banks’ assets are the loans and investments which they make with the deposits provided and whichearn them interest Those assets are held in a variety of forms A substantial proportion is lent outshort-term – either at call (effectively overnight) or in the form of short-term deposits in the moneymarkets (see Chapter 6) The bulk of banks’ assets is held in the form of loans – to individuals and tobusinesses

The banks also lend longer-term, both domestically and internationally In the UK, the loans arevital to the development of industry Most companies start with the help of a bank loan, usually

secured on the assets of a company That means that if the firm folds, the bank has a claim on the

firm’s fixed capital such as machinery or buildings

The proportion of the banks’ assets which they need to hold in the form of cash is known as thecash ratio The ratio has from time to time been set by the Bank of England to ensure that banks

remain sound It determines to some extent the total amount banks can lend However, there are otherfactors involved

One of the most important is the supply of creditworthy customers Banks are normally cautiousabout the people to whom they grant loans If we assume that the number of people who are goodcredit risks (i.e they have a steady job, good references, a good financial record) remains fairlyconstant, that puts a limit on banks’ expansion

The general state of the economy will also affect the growth of bank lending If the economy ishealthy, more businesses will be seeking to borrow funds to finance their investment plans If theeconomy is in recession, however, few industries will be prepared to invest and therefore to borrow.Banks might seek to attract more borrowers by lowering their interest rates, but there is an obviouslimit to such a process The banks cannot afford the return from their lending to fall below the cost oftheir borrowing The return from lending must always be significantly higher, because of the

substantial costs involved in running a branch network

Banks tend to follow a feast-and-famine process Lots of loans will be made in times of economicboom, and when asset prices are rising But when the economy starts to contract, and asset prices fall,some of those loans will fail to be repaid That will prompt banks to suffer losses in the form of

write-downs of their loan portfolios If the bad debts are substantial, as occurred in Japan during the1990s and across the world in 2007 and 2008, the future of individual banks may be threatened

BUILDING SOCIETIES

Building societies face a threat to their long-term survival In retrospect, the decision of a number ofthe biggest societies to turn into banks looks like a mistake All those societies that did so have eithergone bust, or been taken over by high street banks Those who received ‘windfall shares’ at the time

of flotation may feel it wasn’t much of a windfall at all

For a long time, however, societies were perceived as one of the most consumer-friendly elements

of the financial system They were the repositories of the small savings of millions of people and theproviders of finance for the vast majority of home purchases Few folded because of financial

mismanagement

Over the years, societies have grown closer and closer to banks in any case In the old days, theytalked of surpluses, now they talk of profits They compete with banks in terms of offering currentaccounts, cheque books, cashpoint cards, personal loans, foreign exchange, unit trusts and life

assurance

Only in structure are they different Societies are mutual societies, owned by their members

(savers), rather than public companies with shareholders

Origins

The original building societies were literally that – groups of individuals who subscribed to a

common fund so that they could buy or build themselves a house Once the house or group of houseswere built, the societies were folded up

After a rather shaky period in the late nineteenth century, when a spate of society collapses sappedpublic confidence in the movement, the building societies established an important place in the

financial community

The scramble for personal savings increased in the 1980s when the Building Societies

Association’s control over the mortgage and savings rates charged by members gradually weakened.The result was that building societies began to compete more aggressively among themselves forfunds, with extra interest accounts offering instant withdrawal without penalty for the saver Rateswill vary depending on the amount of money invested, the notice needed before withdrawals and thefrequency of interest payments

In some ways, the building society industry was like many others Economies of scale helped

societies reduce costs and that enabled them to offer better rates, pull in more depositors and achievegreater economies of scale

But greater size brought its own dangers At the start of the 1980s, building societies were stillvery small compared with the big banks, but their success encouraged banks to enter the mortgagemarket Competition between the banks and the societies became intense and has remained so nowthat many former societies have converted

Increased competition in the mortgage market meant that societies had to look elsewhere for

profits In the 1980s, there was a big drive to sell endowment mortgages, loans linked to an insurancepolicy which would grow sufficiently (in theory) to repay the capital Endowments earned high

commissions for the societies In the 1990s, endowments became less popular and attention switched

to building and contents insurance

In the savings market, competition has forced societies to abandon some of their long-held customs

In November 1984, the Building Societies Association Council decided to stop recommending

specific interest rates to its members, bringing an end to the interest-rate cartel which the societieshad practised for so long The resulting competition has led societies to increase the number of so-called ‘premium’ accounts which grant savers extra interest if they fulfil certain conditions They alsoattacked the banks head on by offering withdrawals from automated teller machines, chequing

facilities and home banking; no longer is it the case that banks are for current accounts and buildingsocieties for savings accounts

Conversion into banks created an initial bonanza for building society members and put pressure onother societies to convert The Nationwide, the largest remaining society, narrowly fought off a call

for conversion in the summer of 1998 It subsequently made clear that new investors would not berewarded in the case of conversion – an attempt to discourage ‘carpet-baggers’, savers who depositsmall sums in a number of institutions in the hope of benefiting from a spate of windfalls Other

societies imposed minimum investment levels to prevent carpet-baggers cashing in

Enthusiasts for the sector still hope that it can survive Traditional building societies are mutualorganizations, that is they are owned by their savers and borrowers rather than shareholders That hassome advantages to the savers and borrowers Instead of paying out profits to shareholders, the

profits can be used to increase (or for borrowers, reduce) the societies’ interest rates

There are some hopeful signs for building society fans; the Northern Rock debacle may make thebuilding society structure look more attractive If societies can pay rigorous attention to the interests

of their members by keeping down their costs, offering competitive rates to savers and borrowers,and by refusing to sell unsuitable add-on policies just because it earns them commission, then thereshould be a place for them in the twenty-first-century financial system

The Mortgage Business

As noted in the Introduction, building societies perform a piece of financial magic by turning

customers’ deposits, which can be withdrawn at any time, into home loans, extending up to thirty-fiveyears To guard against sudden shortfalls in deposits, they also have limited investments in safe short-term instruments like short-dated gilts For much of the twentieth century, the business of buildingsocieties was extremely sound because of the credit record of its borrowers Most people made everyeffort they could to keep up the payments on their mortgage; and since inflation tended to erode thevalue of the debt, it was relatively easy for them to do so

But the 1980s and the early 2000s saw house price bubbles The profits made by some people fromtheir properties drew more and more people into the housing market Competition from other lenderscaused building societies to lower their credit requirements; some people were allowed to buy homes

on 100 per cent loans, that is without putting up a deposit, and were lent large sums in proportion totheir incomes (Incredibly, a few were allowed to borrow more than the value of their house.)

All this activity was built on the assumption that house prices would rise forever But one bubbleeventually burst in the early 1990s, and the same process seemed to repeat in early 2008 Eventually,prices rise so far (or interest rates go up) that first-time buyers are shut out of the market As the

prospect of easy profits vanishes, speculators also lose heart And the banks and building societiesalso become more cautious about lending As house prices fell, many mortgages became worth morethan the homes they are secured on – a state known as ‘negative equity’ (see Chapter 15)

Negative equity faces lenders with a tricky dilemma Once borrowers default on their interest

payments, societies have the right to reclaim the asset, i.e the house But selling the house would notprovide enough cash to pay off the loan Furthermore, the more homes the societies repossessed, themore empty homes there were on the property market, depressing house prices and giving an extratwist to the downward spiral

The Mortgage Rate

The mortgage rate goes up or down with the general level of rates in the economy The building

societies cannot stay separate from the other financial institutions, since they must compete with themfor depositors and they must sometimes borrow from them As the cost of raising their funds rises andfalls, so must the mortgage rate In general, however, the mortgage rate is slower both to rise and tofall than bank rates

As interest rates rise and fall, societies switch their concern between savers and borrowers In

1990, when base rates were 15 per cent, the typical mortgage rate was just a fraction above thatlevel, at 15.4 per cent Societies were holding down the rate to prevent any more pain being inflicted

on homeowners In late 2001, when the Bank of England cut rates to 4 per cent, many building

societies were charging 5.5 per cent, a margin of 1.5 percentage points The societies had switchedtheir concern from borrowers to savers

A big change in the 1990s came with the development of fixed rate mortgages These promiseborrowers a set rate for several years at a time, allowing them to plan their budgets and avoid thedanger of a sudden jump in rates The catch is that borrowers do not benefit if rates fall and, if theytry to repay the loan ahead of time, they face heavy redemption penalties

Building societies fund fixed rate deals by borrowing in the wholesale markets The problem thatemerged in 2008 was that wholesale markets were either closed to new borrowing, or extremelyexpensive to access The result was that homebuyers seeking fixed rate mortgages found that loanswere either withdrawn from the market or became a lot more expensive That did not help a housingmarket that was already struggling

Investment Banks

Most people have a pretty clear idea of what retail banks do: take deposits and make loans But thepublic understanding of investment banking is far less developed Perhaps the first time they really hitthe headlines was in the crisis of 2008, when in effect, independent investment banks disappeared.Three of the leading five banks in the US lost their independence (or went bust) within six months; theother two (Morgan Stanley and Goldman Sachs) applied for commercial banking status

But while the banks may have vanished or mutated, the business of investment banking goes on InBritain, the sector used to be known as merchant banking; investment banking was the American term.Investment banking is only part of the activities of the likes of Merrill Lynch and Goldman Sachs,which are also known as broker-dealers, and larger banking groups such as Citigroup or Union Bank

of Switzerland have their own investment banking arms

The key change of the last twenty to thirty years has been that investment banks no longer depend onfee income for the bulk of their profits Now they put their capital at risk through trading and

underwriting This has hugely increased their importance and, as we saw with Bear Stearns and

Lehman Brothers in 2008, the risk they pose both to their own financial health and to the system

Broadly speaking, the investment banks earn their money from four areas: advising clients on

everything from takeovers to how to handle currency risk; broking (connecting buyers and sellers inreturn for a fee); trading in the markets; and asset management (looking after other people’s money)

The roots of the industry grew out of trade Before the development of a worldwide banking

system, much international trade depended on trust – trust that goods would be delivered and that theywould be paid for It was much easier for overseas clients to trust merchants with whom they hadtraded before or those with whom their friends had traded Thus, the larger and well-establishedmerchants found it easier to trade than their smaller and less familiar competitors

The smaller firms needed some way both of assuring their clients that they were trustworthy, and ofraising money to cover the interval between the time goods were delivered and the time they werepaid for The normal method for raising finance in this period was for the exporter to draw up a bill

of exchange, whose value was a large proportion of the value of the goods being sold The exportercould then sell the bill to a local banker at a discount and receive a substantial proportion of the

money in advance The extent of the bank’s discount would represent two elements, a charge

equivalent to interest on what was effectively a loan and a charge reflecting the risk of non-payment.Small exporters found the banks would often charge a very large discount to advance money ontheir bills, if they agreed to do so at all So the smaller merchants began to ask their larger brethren toguarantee (or accept) their bills In the event that the small merchant failed to pay up, the large

merchant would be liable In return for the service, the large merchants charged an acceptance

commission, based on a percentage of the size of the bill

Eventually, some of these large merchants found that they could earn more money from their financeactivities than from their trading and became full-time merchant banks or accepting houses For a longtime, their business was centred around the financing of trade but gradually, as they developed a

reputation for financial acumen, they increased the corporate finance side of their activities

Many merchant banks were begun by immigrants, refugees or Jews, shut out of the rather stuffyworld of the clearing banks The wheeling and dealing involved appealed to the more adventurousspirits However, the business was so lucrative that the merchant banks became absorbed into the

mainstream establishment.

From the 1950s onwards, merchant or investment banks used their financial expertise to help theircorporate clients, advising on share issues, bond issues and takeovers For this, they were rewardedwith fee income, a very good business in boom times Unlike their commercial banking rivals, theyhad no need to maintain a vast branch network Their fixed costs were low; their profits-per-

employee high

But, as we saw in Chapter 1, the international financial markets changed in the 1980s Large

companies no longer needed advice alone; they needed banking advisers who could commit capital todeals The clients wanted the assurance that, if things went wrong, the investment bank could ensurethat the money was still raised

That spelled the end for the old British-style merchant bank, which was often a private business,run by a small group of partners It also meant that, having raised large amounts of capital, investmentbanks started to move into new areas They used their expertise to deal on their own behalf, throughproprietary trading desks They sold their expertise to clients as asset managers They dreamed upexotic new products, particularly in the derivatives markets, and sold them round the world They lentmoney to favoured clients such as hedge funds and private equity groups (see Chapter 9)

This has earned investment bankers a lot of money But it has also brought them to the heart of theglobal financial system It was significant in March 2008 that the US Federal Reserve felt obliged tohelp with the rescue of Bear Stearns, an investment bank The bank had no retail depositors Therewould have been no queues of worried consumers, as there were at the British bank Northern Rock.Neverthless, Bear Stearns was deemed too big to fail (TBTF in the jargon), or even TCTF (too

desire While everyone involved tried to work out their exposure, the markets could have been

frozen

When the US authorities changed tack in September 2008 and allowed Lehman Brothers to failover a weekend, the consequences were immediate Merrill Lynch decided not to take the risk ofdepending on market support and opted for a takeover by Bank of America A lack of investor

confidence caused AIG, a huge insurance company, to have trouble raising capital, sending it into thearms of the US government The cost of borrowing money in the banking sector soared, and shareprices of the remaining investment banks came under attack The US Treasury was forced to dream up

a $700 billion bailout plan to buy the mortgage-related assets that were undermining bank balancesheets For a few weeks the financial markets seemed to freeze completely

In short, the huge change in the international financial markets, which has allowed capital to flowfreely across borders, made investment banks just as important as commercial banks Indeed,

investment bankers often make the system tick by acting as market makers; they offer to buy or sellshares and bonds at a given price in the market

In theory, market markers can make money through the spread – by buying shares or bonds at alower price than they sell them But in an electronic market with thousands of players, it can be quitedifficult to make a lot of money this way So they end up betting on trends in the markets – trends that